Reconsidering Murphy: Restorative Payments vs. Return of Human Capital

Last year’s Murphy v. United States decision was one of the most controversial tax cases in recent history. Unlike many other tax attorneys, I am not sure that I agree that the Murphy case was wrongly decided. One reason for this is that, in thinking about Murphy, I find it difficult to reconcile why “restorative payments” are tax free, yet payments that are a “return of human capital” are subject to tax.

In Revenue Ruling 2002-45 the IRS held that amounts paid by an employer to employees to compensate employees for losses associated with improper investments held in the employer-provided defined contribution plan, if the contributions are paid into the qualified plan, are not considered “contributions,” and, are not subject to the contribution limits. Instead, the amounts are considered “restorative payments.” According to the IRS, these “restorative payments,” up to the amount lost, are compensation for breach of a fiduciary duty and not for losses due to market fluctuations.

The IRS has now, in Private Letter Ruling 200705031, applied this logic to IRA payments where a taxpayer received a “restorative payment” from a financial institution to restore losses resulting from the financial institution breaching its fiduciary duty to invest prudently. The IRS made this ruling even though the taxpayer held the “restorative payment” in a separate taxable account and the taxpayer missed the sixty day deadline for contributing the “restorative payment” to another IRA.

These private letter rulings do not expressly address or state whether these “restorative payments” are taxable income to the recipients; however, the IRS, in Private Letter Ruling 200137065, under similar facts, did expressly state that “restorative payments” were not taxable income to the recipients (if “restorative payments” are taxable income to the recipients, it seems that the taxpayers should be allowed to contribute a “restorative payment” in an amount up to the amount of the loss plus the taxes imposed on the “restorative payment” — rather than just an amount up to the amount of the loss).

This “restorative” analysis sounds very similar to the controversial “return of capital” analysis employed by the D.C. Circuit Court in last year’s Murphy case.

In the Murphy case, the court held that amounts recovered for non-physical personal injuries (emotional distress and loss of reputation) unrelated to lost wages or earnings are not taxable income, because such payments were merely payments to return “human capital” – with “human capital” essentially being a non-taxed entity – because the loss results from the actions of a third party.

Compare that to “restorative payments,” which are non-taxable payments to restore funds to defined contribution plans and IRAs – which are non-taxed entities – because the loss results from the actions of a third party.

Is there really a difference between “restorative payments” and payments that are a “return of human capital?” If so then the rule is that payments to compensate a taxpayer for someone harming the taxpayer’s retirement account are tax free, yet payments to compensate a taxpayer for someone harming the taxpayer’s person are taxable?

The DC court has since vacated its Murphy decision and it has opted to rehear the case (apparently due to the negative reaction from the tax profession to the court’s analysis). I have not read the briefs for that rehearing, but perhaps the taxpayer raised this issue and/or the court will take the time to explain the difference between these two types of payments.